How To Short The Canadian Real Estate Market Using Options

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OH CRAP, MORE ON OPTIONS. I’d suggest finding a knife and slitting your wrists in advance. Or, you know, not doing that.

If you’ve been around here for longer than 20 minutes, it’s no secret that I think Canada’s real estate market is massively overvalued. In fact, I’ve wrote about it more often than Trent Hamm’s ode to the wonders of the coupon. At this point, this blog is nothing more than penis jokes, chicks in bikinis and pieces on why our houses are so damn expensive. Depending on your perspective, I’d either be the lamest or best party guest ever. At least until I wore the lampshade as a hat.

Anyway, if you want a more detailed version of why I think this way, go click the link and see all the reasons why I want to short it. The condensed version is simple. Every metric indicates the market is overvalued, especially in Toronto and Vancouver. Home ownership rates are the highest in history, even surpassing the United States at the top of their bubble. Recent changes in mortgage rules have made houses harder to qualify for, making it harder for the few remaining first time buyers to buy.

Markets are starting to roll over. The average home in Toronto has declined 7% in value in the past 6 months. In BC, the average price has declined more than 5% over the same period. The number of transactions in both provinces have fallen more than 10% compared to last year’s numbers. Other markets are holding up slightly better, but it’s obvious the decline has begun. Hell, my town of 8,000 reported only 1 sale in the month of October, at least according to a local realtor.

That’s great, but how do we make money at this? I have an idea. Keep in mind though, I’m still analyzing this particular play. None of my money is currently trying this strategy. I’ll announce it if/when I do. With that out of the way, here’s the idea.

Short Home Capital Group.

Home Capital Group is Canada’s largest “alternative” lender. (alternative meaning subprime, although not nearly as bad as you FILTHY AMERICANS) They lend primarily to people with bruised credit or to self employed folks, borrowers usually more shunned by big banks than me if I were to go to the Playboy Mansion. They have three divisions, one lends to people who qualify for CMHC insurance, one lends to people who don’t, and the third is a consumer lender. We’re going to focus mostly on the non-insurance division.

First of all, let’s take a look at the company’s growth in the last few years. They’ve slowly moved away from the insured mortgage business (which they refer to as their securitized portfolio) and moved into non-insured business. Check it out.

Yep, this is what I do with my spare time

In the short term this is good for the company, since these non-insured mortgages tend to come with higher interest rates. The bad news is there’s typically a reason why CMHC won’t insure these borrowers, and that’s because they’re a credit risk. What’s important is that you see how the company is purposefully moving in the direction of riskier borrowers in return for higher interest rates.

It’s working pretty well for the company right now, thanks to two factors: low interest rates and increases in house prices.

The company boasts that their average loan to value ratio on the traditional portfolio is 70%, a figure people bullish on the company like to point out, usually with a sneer that makes me want to weep softly. Which is all fine and good, except that means that half of their mortgages are above 70%. That part of the company regularly lends up to 80% loan to value. Prices have been going up, so it’s worked out fine. Plus, the average interest rate of these loans is about 5.5%, making the payments affordable.

From the end of 2011 to the end of September 2012, the company has grown the non-insured part of the business by over 33%. During 2011, the same division of the company also enjoyed impressive growth, growing close to 30%. From our perspective, that means over half of the mortgages on the company’s balance sheet were issued during the top of the market.

It gets better. The company disclosed that over 75% of their loans are made on homes in Ontario. They don’t go any further than that, but it’s safe to assume a huge percentage of the company’s fortunes are tied up in Toronto. The second largest lending area is BC, with a mere 7% share.The company is very sensitive to a decline in Toronto’s real estate.

If you scour the company’s latest quarterly report, they start talking about high rise condos. They only represent 7% of the total portfolio, and over half of condo loans are insured. They also have a lower average loan to value ratio. Since Toronto’s condo market is particularly frothy, this is a major point against going short this company.

While it’s not perfect, I think Home Capital represents a reasonable proxy to the overall market. As values decline, so will the price at Home Capital, even if we don’t see the massive foreclosures that we saw when the American market crashed. Market sentiment will take over from there, perpetuating the decline. Remember what happened to U.S. financials in 2008-09? Picture that, just not quite as bad.

Here’s what you can do. You can buy puts on the company. Remember from Wednesday that you buy a put on something you want to go down, since a put gives you the right to sell the company’s shares at a certain price. You can do it either one of two ways – go for the big gain or a series of small gains.

The July 13 $48 put is currently trading at $3.00. (meaning it gives you the right to sell on July 31st, 2013 at $48 per share) It’s currently the longest term put with the lowest strike price. If you buy it and the company falls from its current stock price just above $52, you’ll be sitting on a gain. Say the company falls from $52 to $42 from now until July. Once you factor in the $3 premium paid for the put, you’ll have the right to sell 100 shares at $45. That $3 per share difference is your profit, and is a cool 100% return on your original investment.

The downfall is that you’re going to lose all your money if the stock doesn’t fall to $45. (Aside: $3 is expensive for this option. It appears I’m not the only one with this idea)

Meanwhile, you could buy the $52 Jan puts for $1.90, meaning the company just has to fall below $50.10 for your option to be in the money. If the company falls to $49.50 during the next two plus months you’re looking at a cool 30% return on your original investment. I’d put the likelihood of that happening at a significantly higher percentage than our first example. Even if the company falls to $51 at some point, the put should be worth more than what you paid for it, so you could even sell it to someone else for a profit.

And that’s it. That’s how you can short the Canadian real estate market using tools available to any investor. I’m just not sure if you should try it or not. How’s that for confidence?

6 Comments

Chris
on November 23, 2012 at 9:23 am

Interesting – but like you said, a lot of people seem to be thinking this as well? Just wondering what you think of MCAP and MIC, who I believe are in the same sort of business. They trade at what looks like a pretty good value, in a long term way – unless they get absolutely crushed. Any compare and contrast posts upcoming? thanks

If they only lend to a max of 80% LTV, then substantially more than half of their mortgages would be above 70% — after all, it takes two mortgages at 80% to average out with one at 50% and end up with 70% overall.

I’m still in the long process of examining HCG (already short MIC). Puts would be a really nice way to get short in theory, but without LEAPs here I don’t think it’s a way to go — you can build the case that it’s going to go down with the housing market, but the housing market is so slow it’s too hard to time the puts. July is only 8 months away, and the Toronto market might just be starting to report YoY declines. The stock could anticipate a housing bust and crash tomorrow, or it might take another few years for the problems to really show up through defaults. OTOH, the cost to borrow to stay short for 2 years running might be less than the cost of buying puts three or four times over.

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How is this idea looking currently? My in-laws are in a suburb on Toronto and I sense that they’re home is still extremely over-valued. Should I assume the Canadian housing bubble has yet to burst? Maybe the tipping point is just taking longer to reach? Perhaps NOW is an excellent time to try this put?

A quick glance at the options indicate they’re pretty expensive. The time to try this was six months ago before the TSX hit the crapper. Of course, if the housing market does implode, there’s still plenty of upside potential. FWIW, I gave up on this trade. Getting the timing right was too hard.